The blockchain has brought two innovative concepts that are changing how people do business in the financial world. Those two concepts are non-fungible tokens (NFTs) and decentralized finance (DeFi). While they are two separate ideas--together, they can reimagine the future of finance.
What are DeFi and NFTs?
DeFi describes the shift from a traditional financial system to a peer-to-peer financial system on the blockchain. DeFi promises to deliver an open financial system to anyone with an internet connection. This benefit is especially appealing to those living in countries that don't have reliable banking systems. With no third-party interference, DeFi experiences significantly less fraud and gives people more sovereignty over their finances.
NFTs are unique digital assets on a blockchain. Because they are unique and immutable, they are also less prone to fraud. Many industries, from gaming to music, have decided to use NFTs as a means to verify authenticity. Together, NFTs and DeFi offer many use cases through more trustless, decentralized systems.
The DeFi industry allows for quick and efficient financial operations, including lending, borrowing, trading, and investing, without needing a centralized third party. Smart contracts permit automated financial transactions, reducing the chances of fraud and errors and making the process much more efficient.
Using the blockchain gives users a level of transparency that traditional financial institutions don't allow. The data and information for each transaction are stored on a ledger that anyone can access. Users can track and verify the authenticity of data and transactions.
NFTs live on the blockchain like other cryptocurrencies, but, unlike many cryptocurrencies, NFTs are unique and irreplaceable. Merging a DeFi system with non-fungible tokens that authenticate ownership creates a new world of possibilities.
Uses for NFTs in DeFi
The principles of DeFi can be applied to NFTs and here are some of the best use cases.
NFTs are often used in DeFi as a collateral asset. Instead of putting up your house or a car to secure a loan from a bank, NFTs can be used as collateral for a loan from decentralized protocols. That factor reduces lender risk and allows loans to be offered to a wider range of users. It's also a much more efficient use of your capital since you can use the digital asset as collateral for loans.
The entire process is simple. The borrower deposits the NFT into a smart contract, which the lender evaluates before assigning the loan to value ratio. A new token is minted and pegged to the value of the NFT deposited. NFTfi and Arcade are some of the largest peer-to-peer NFT lending marketplaces currently operating.
Fractional ownership allows multiple parties to own a portion of an asset. Many NFT collectibles are too expensive for the average person to purchase, so fractionalizing a particular NFT allows for people to own smaller, more affordable fractions of that NFT. Fractional ownership gives each person a percentage of the NFT based on the amount they invest.
You can own a portion of the NFT without paying full price and this increases the group of potential fractional NFT buyers. Fractional ownership also improves liquidity since the value of the NFTs can be sold more easily, expanding the range of decentralized financial access.
NFTs are also being used to represent insurance policies. They help automate the insurance process, so there's less fraud and human error. All the user has to do is buy the NFT representing the policy. Instead of a claims processor, the smart contract would be used to verify whether or not a claim should be paid.
Evertas was established in 2017 and now supports a large portion of underwriting globally, according to their website. They are leading the way in this space of the decentralized finance world and supplying a framework that other insurers can use as a blueprint.
In May 2022, Superscript and Lloyd’s of London insurance market broker joined forces to create a product for the Web3 economy. The product’s name is “Daylight” and is the first digital asset-dedicated product to be offered by a Lloyd’s broker.
Tracking and managing debts on the blockchain are streamlined when an NFT represents each debt, creating an easy and secure transfer of ownership and tracking. Smart contracts can be implemented to automate the debt management process. The entire transaction, from the creation of the debt to the repayment, is all captured on the blockchain, so there's no room for error or fraud.
If the debt cannot be repaid, the smart contract would transfer the NFT to the lender on the blockchain. NFTfi is one company using a peer-to-peer lending platform with that stipulation built into its smart contract contracts. Arcade is another lender using the same model as NFTfi. Since its launch Arcade has disbursed $20 million in loans.
Asset tokenization is the process used to create a digital representation of a tangible physical asset on a blockchain. An NFT is used to ‘tokenize’ the physical asset, making it easier and more secure to transfer ownership and track the asset on the blockchain. For example, StockX has ‘tokenized’ ownership of physical sneakers by creating NFTs that represent ownership of the sneakers. People can buy, sell, and trade the NFTs much more easily than the physical sneakers. Theoretically, every physical asset could be minted into NFTs that represent ownership in the physical trade and can be traded as a financial asset.
As another example, NFTs can also represent a derivative contract for options trading. That allows traders on DeFi platforms to trade on a peer-to-peer basis just as they would if using a centralized exchange.
A trader can purchase an NFT that represents a call option on Ethereum. If the Ethereum price goes up, the trader makes a profit. But, if the price goes down, the trader will lose money.
Synthetic assets can also be created using NFTs. These assets don't have a physical counterpart but represent another asset. To give you an idea of what this looks like, imagine an NFT representing a company’s stock share. The NFT can be traded on a decentralized exchange as a synthetic asset.
The Risks of DeFi and NFTs
As with any emerging technology, risks are involved. Scammers take advantage of a lack of regulation currently in this industry. NFTs, like almost anything on the internet, are also at risk of being hacked.
Another concern is smart contract security breaches. Typically, a considerable amount of money is stored in the smart contract that hackers are very attracted to. Money will be lost if they gain access to smart contracts and trust in the DeFi space will also diminish.
Check out this video from Forbes, where Olaf Carlson-Wee, a top venture investor in crypto as he explains why he believes in DeFi — Meet The Crypto Pioneer Leading the DeFi Movement.
DeFi and NFTs, What’s Next?
The changes that DeFi NFTs are making in the finance industry are profound. The control that banks and other financial institutions have over money, services, and products is significantly diminished in the DeFi NFT space. The technology is still in its early stages but is promising to offer solutions most are willing to try if it grants them complete control of their assets.
Q: What is DeFi? What are NFTs?
A: NFTs are digital assets on a blockchain, and DeFi is decentralized financial technology.
Q: What does DeFi stand for?
A: DeFi stands for decentralized finance.
Q: What are the top DeFi coins?
A: DAI, UNI, and AAVE are among the most popular.